Friday, 4 July 2014

Global Economy - Half-time Report

It is game on in
Brazil but many are hoping for less thrills in the financial markets in the
second half of 2014

Just like in a football match, the half-way point (of 2014) is
a good time to assess progress so far and look ahead to the second half. The first six months have been relatively boring
but in a good way, after participants and spectators of financial markets have been
riding by the seat of their pants over the past few years. The game plan so far has been an emphasis on
defence with central banks in Europe and Japan providing more support for their
economies while tapering by the Federal Reserve has been at a measured pace. Investors are betting on a quiet second half
to 2014 but this will depend on whether the markets can hold their nerve when
confronted by the prospect of tighter monetary policy.

Tension is building

The start of 2014 could be considered a success on a number
of fronts. There are reasons for
optimism in terms of the economic recovery such as swiftly falling unemployment
in many countries. Share markets are
buoyant suggesting that investors are willing to take on risk. Interest rates on government debt have
dramatically fallen for most countries in Europe whose debt has previously been
shunned by investors. The focus of
policy makers is no longer on dealing with the potential for crisis but instead
on bolstering the economy recovery.

The only problem with this is that much of the progress has
been built on loose monetary policy which is due to come to an end. Investors will have to manoeuvre around the
winding up of quantitative easing and higher interest rates. This will be like a football team losing one
player in defence – not the end of the world but it opens up the potential for calamity. One consequence is that it is unclear how the
second half of 2014 will play out.

May 2013 proves us with one example of what is likely to
happen sometime soon . In this month
last year, financial markets went into spasms as the Federal Reserve signalled that it would
cut back on its monthly bond purchases that constituted its quantitative easing
program. A repeat of what has since been
labelled “taper tantrum” seems likely but with higher interest rates as the trigger
(maybe prompting headlines of “rates rampage”).
Another popular phrase has been “fragile five” after countries who suffered at the
hands of financial market who can turn nervy at any time.

When will things kick
off?

The game plan from policy makers adopted so far this year is
likely to stay in place considering the relative calm in the financial markets. The aim will be to not let in any goals (especially
any own goals) rather than pushing to score gains in economic growth. As a result, it is tough to see any big
changes in the economy itself. Dramatic
improvements in the economy are not likely with governments continuing to mend
their finances. Loose monetary policy may also not be as useful as hoped in boosting spending by consumers or investment by firms even as
the economy shows sign of getting a second wind.

Whether the benign economic conditions continue into the next
six months depends on the fickle nature of investors. Like an erratic football striker who often
gets stroppy, investors need to get their way in order to be kept happy. Central banks will likely take a cautious
approach so investors don’t retreat to the side-lines. This is likely to result in the first hike in
interest rates by the Bank of England, which is ahead of its peers in this
regard, being pushed back to at least next year. Further reasons for delay include other policy options being
available to the UK central bank and a likely negative effect on the pound from any rise
in interest rates. Others such as the
European Central Bank and the Bank of Japan likely have even more to offer in
terms of loose monetary policy to play ball with investors.

The football world cup in Brazil has been notable for its outstanding
goals and nail-biting action. In
contrast, many will be hoping that the financial markets in the second half of
2014 will be as exciting as a nil-all draw. But just like a game going into
extra time and penalty, some excitement is inevitable as monetary policy
tightens and it is something that the financial markets will have to cope with this
year or next.